Economics

Debt

The low-growth threshold

CARMEN REINHART and Kenneth Rogoff received widespread acclaim for their book "This Time is Different", which documents patterns of financial crisis, recession, and debt crisis over the past 800 years. A more recent collaboration—a paper entitled "Growth in a Time of Debt"—has not been received as warmly. As background, here's a bit of the abstract from that paper:

Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more...

This conclusion has provided some of the foundation for fledgling efforts to address long-run debt (such as Barack Obama's deficit commission), but it has also been used in pieces arguing that new fiscal stimulus might be a bad idea.

Paul Krugman, in particular, has targeted the paper's results, using two main criticisms. First, it is difficult to determine causation when studying debt/growth dynamics. As the last few years have demonstrated, slow (or negative) growth rates hold down revenues, leading to ballooning deficits and higher debt levels. If causation primarily runs from growth to debt, then pro-cyclical austerity measures are a poor solution. Second, Mr Krugman criticises the use of key datapoints in the paper, namely, those corresponding to the postwar years in America and Britain. At that time, debt levels were high due to war spending, and growth rates were extremely low thanks largely to military demobilisation. It would be a mistake to draw much in the way of a broader conclusion from this. In a new post, Mr Krugman cites a paper by John Irons and Josh Bivens which looks to refute the Reinhart-Rogoff conclusion. It includes this image:

What we see here is a scatterplot of American growth rates and American debt levels, over the whole of the country's history. And the only years of low growth that correspond to debt levels above 90% are 1945, 1946, 1947 and 1949.

This inspired me to re-read the Reinhart/Rogoff paper. The first point that jumps out is it's not all about America. Reinhart and Rogoff's data cover 44 countries. not just the US. The 90% figure relates to 20 advanced countries. So I recalculated the advanced country numbers (p12 of the paper) to leave out the US. The simple arithmetic averages are as follows; growth in countries where the debt-to-GDP ratio is less than 30% averaged 3.5%; at 30% to 60% levels, the growth rate averaged 3%; at 60%-90% levels, the rate was 2.8%; above 90%, the growth rate was 2.3%. As you can see, growth does get slower as debt levels rise.

Of course, that still leaves the causality point. But think of the problem a different way. The best way of solving a high debt problem is economic growth. Clearly, however, countries have struggled to grow with a high debt level. So it seems best not to take the risk. As for the deficit/stock argument, governments with a high debt-to-GDP ratio will inevitably be paying a lot in interest payments; either these drive up the deficit or they would crowd out more useful forms of public spending such as roads or education.

So while the general criticism, that there is no "magic" level of debt-to-GDP, is a fair one, the Reinhart/Rogoff paper can't be dismissed so easily.

I'd just make a couple of points. One is that other things equal, a lower debt level is probably preferable, if only to keep dry powder on hand should recession or other emergencies arise. Another is that it's worth thinking about the mechanisms that are (potentially) involved here. High debt levels might slow growth by crowding out private investment. That process would ordinarily be associated with rising interest rates on government debt, which aren't currently a problem for America. That could change, of course, but it is worth pointing out that based on the analysis in the much-cited Alberto Alesina paper connecting austerity and growth, one of the key causal relationships is the effect of debt reduction on high interest rates. Meanwhile, Ms Reinhart and Mr Rogoff specifically cite the need to use growth-slowing tax increases and spending cuts to whittle down debt as a factor connecting high debt and slow growth. But as Buttonwood mentions, growth is one of the best ways to reduce debt. It seems feasible that a strategy of ignoring debt and focusing on growth could be as effective as ignoring growth and focusing on debt in breaking the debt-growth relationship. This all seems strangely circular and confusing, but that's part of the problem in conducting this kind of analysis.

Debt matters, but the precise way that it matters isn't as clear-cut as Reinhart-Rogoff seem to indicate. And simple extrapolation from their results to demands for across-the-board austerity isn't a wise approach.

Readers' comments

The fundamental point is that politicians are spendthrifts - and will not stop being so until forced. Every country that allows politicians to follow their natural instincts will end up in a debt trap.

After decades of running ourselves deeply into debt to support tax cuts for the best off among us, it is entirely insane to worry about large deficits when faced with the worst economic downturn since the Great Depression. Insane ! Of course, it is not insane to pretend that you are worried if you are a Republican.

Odd. Krugman would accept studies like the one of Blinder and Zandi in the article below this one at face value because it supports his ideology. So the test of good empirical analysis seems to be how closely it supports one's predetermined conclusions.

So what happened to the idea that empirical studies will solve all theoretical disputes? Doesn't seem to work out that way. Everyone falls back on logic (gasp!) to analyze the methodology and interpretation of the data and results. And that's as it should be. In economics logic is a far more certain path to truth than is empirical data.

Another way to interpret Reinhart and Rogoff is to consider the correlation between high levels of state debt and state intervention in the economy. The debt itself doesn't matter so much. A relatively free market economy my be able to sustain very high levels of debt. That was true in the case of the Dutch Republic of the 17th century. The Dutch had very high state debt because the English and French attacked them every decade. It would be interesting for Reinhart and Rogoff to add a variable related to economic freedom, such as the AEI's Index of Economic Freedom, and see if that reduced the effect of debt any. I'm guessing it would.

Debt should be used sparingly if at all by the state because of the peoples innate thirst for safe investments. People thirst for safe investments mean that they will tend to invest in gov't bonds rather than the private sector where their monetary investments carry more risk. By encouraging investment in the private sector and the use of private means to acheive basic life goals we all have such as university education, good health & healthcare and a decent retirement government can both boost the economy and it's citizens futures.

1) Beware of any sort of "cut-off" in statistics. There likely isn't a universal tipping point at 90% Debt:GDP that applies to all situations. This feels like a "multiple endpoints" trick.

2) The four years mentioned as the "only" ones over 90% Debt:GDP with negative growth happen to be the highest 4 Debt:GDP ratios in the history. If one wants to ignore the other circumstances in the economy outisde of government debt and insist on claiming a tipping point, then maybe one should simply conclude that in the US, ratios above 100% (or wherever the 1949 value is) lead to negative growth. Is that really all that much different than what R-R claim worldwide?

3) Private debt matters. And it's still sky high. The citizens of the US are reasonable for both its private and public debt, and aren't in a great position to take on much more. But this is hidden when you focus on only government debt.

Well, no, we haven't lost all perspective. In the Buttonwood quote, we're talking about the difference between 3.5%, 3.0%, 2.8%, and 2.3%. Total difference is 1.2%, but that value is just over one-third of the best-case growth (3.5%). So, losing a third of your growth is rather more of a big deal.

It's a bigger deal when you need to create a huge number of jobs to soak up all the unemployed workers. Spending all this money to create jobs might soon hinder the growth that we need to create jobs. That's kind of important.

Of course, Rosie the Riveter lost her job, but the lucky ones had boyfriends/husbands/brothers come back from the war.
Remember, back then people didn't need cableTV, cell phones, 2 cars,
etc.
Heck, the men getting out of the Armed Forces were probably happy not to have to sleep in a foxhole, tight quarters of a ship/sub, or squeezed into a barrack, with little privacy.

As consumer demand rose, so did inflation because the economy needed to change from war production to consumption production.

Inflation:
1945: 2.3%
1946: 8.3%
1947: 14.4%
1948: 8.1%
1949: -0.4%

And also remember, that back then, America was the only country standing.

Debt is a trap. Too much of it and you can't grow as well, but you need the growth to pay off the debt. Simple extrapolation from their results to a greater aversion to debt than Washington currently displays is perfectly reasonable, even healthy.

Lost in the repetitive citation of the R&R paper is that it speaks of lower growth, not an end to growth or contraction. If you take the quote from Buttonwood, the argument is about .7% per year from lowish debt to really high debt. And that's not considering all the other policy sources of growth or contraction or the differences from country to country.

So what exactly is the big deal? This paper is being cited as an argument that the debt must be cut now, period, end of story, or disaster awaits, and yet the disaster in the paper is a marginally slower growth rate some of the time in some countries. Wow.

So I have a question: have economists lost all perspective? All this heat and light about debt levels and one would expect the paper - which I've read and have on my computer - to say that the END IS NIGH and yet the actual point is that "we may slow down a little." Are you all nuts? Are you all headline junkies? Do you not read the papers in your field? Do you rely on political operatives to spin stories that you then react to?

There may be a correlation between debt and growth rate but the corelation may be either way. In fact a country may borrow money to build productive capacity or to modernise the economy in which case maney borrowed today will bring prosperity tomorrow through higher growth rate. If a country borrows money to spend on unproductive activities then of course the debt burden will impact negatively on growth. So there is need for indepth analysis on the nature of the debt for a clearer picture. Just by looking at figures we may not be drawing the right conclusion.

I am surprised to have seen less on the possibility that there may indeed be a correlation between growth and debt, but that it could go the other way. There was a good post on Worthwhile Canadian Initiative about that a week or two back.